Transaction Costs and Trading Activity in the Index Futures Market: The Case of the Transaction Tax Reduction in Taiwan

Abstract

This study is designated to investigate the impact on market quality stemming from the reduction in transaction tax during the early stages of the development of Taiwan Futures Exchange (TAIFEX). Alongside an examination of the various impacts on market liquidity, volatility and government tax revenues arising from the transaction tax reduction, we also test the relative pricing efficiency of the 'cost of carry' model in both the pre- and post-tax reduction periods. Furthermore, in order to provide an insight into the growing competition between closely related index futures, we also examine the spillover effects of the transaction tax reduction on the trading volume of its foreign competitor, the Singapore Exchange (SGX). Our results indicate that the reduction in the tax rate has improved both the liquidity of the index futures and government tax revenues. We find that a reduction in transaction costs increases the public quote depth of an order-driven market, such as the TAIFEX. In addition to the reduction in volatility in the futures market, the tax reduction is also shown to mitigate the extent of prevailing pricing errors. We also find that the transaction tax reduction has led to an increase in the long-run growth of the trading volume in the TAIFEX, whilst reducing its foreign competitor's growth rate of the trading volume. Our results therefore support the hypothesis that a reduction in transaction costs increases the competitiveness of the futures exchange.